Tutorial 8: Portfolio Allocation II: CAPM & ALTINVESTMENTS Flashcards
CAPM and the case for alternative investments
▪ In the CAPM world, investors consider the potential risk or variance - which is the … produced by an asset - against the expected returns of that asset (this is the essence of …) by building a …
▪ The perennial case for alternative assets is that they have a…, meaning they don’t necessarily move in the same direction as other assets when market conditions change
▪ Different …
▪ Illiquidity leading to …
But careful!
▪ Sticky prices can make assets appear less risky than they are in reality
▪ Some alternative assets have a high likelihood of …
volatility of returns; mean variance preferences; multi-asset and asset class portfolio.
low correlation to standard asset classes
return profiles compared to standard asset classes
sticky prices
large losses, or ‘tail risk’
Challenges in illiquid asset valuation:
1. The risk of illiquid assets is difficult to measure. Explain why. (2 reasons; hint: consider how they are priced; and how they are perceived)
- Fair values are difficult to determine and are prone to principle-agent problems. Why?
Illiquid assets are priced based on appraised or backward looking valuations leading to sticky prices which may appear artificially smooth. They can be perceived to be less risky than they truly are because illiquid assets can appear less volatile than risky assets.
Investors (LPs) depend typically on reporting provided by the fund manager to determine the value of their illiquid investment stake. To minimise risk from conflicts of interest, this valuation committee should have both internal and external people but in practice it is not always the case.
What are hedge fund tail risks?
They represent a high likelihood of large losses.
A high tail risk –> returns are not normally distributed
Std dev. is a poor measure of risk as it does not account for tail risk or skewness
Observing maximum drawdowns or maximum losses may be a better way to measure the risk of these assets
Explain the power law curve of venture capital.
VC deal-by-deal return distribution follows a power law, with a few winners accounting for more returns than all others combined.
Why “power”? Successful startups tend to have an exponential arc to them. Maybe they grow at 50% a year and it compounds for a number of years…
Calculating Beta for illiquid alternative investments
▪ The case for the traditional asset beta is well established, easy to demonstrate and therefore readily applied to investing.
▪ Some alternative investment (e.g., …, listed real estate investment trusts, …) can be traded on exchanges.
▪ Many others (e.g., …, Private Equity/Debt, Collectibles) are illiquid and …
▪ Betas for illiquid alternative investments are not easily observable, as we … and hence, correlation to the market.
▪ However, there are still ways and means by which one can…
listed private equity; most commodities
Hedge Funds; can’t be easily sold or otherwise converted to cash.
cannot observe continuous price movement
approximate betas for non-traded investments.